Revision 6 – Business Valuations
Answer 1
(a)(i)
Balance sheet value = $454,100. [1 mark]
(a)(ii)
Replacement cost value = $454,100 + $(725,000 – 651,600) + $(550,000 – 515,900) = $561,600 [2 marks]
(a)(iii)
Realisable value = $454,100 + $(450,000 – 651,600) + $(570,000 – 515,900) – $14,900 = $291,700 [2 marks]
Bad debts are 2% x $745,000 = $14,900. Bad debts are assumed not to be relevant to the statement of financial position and replacement cost values.
(a)(iv)
The dividend growth model value depends on an estimate of growth, which is far from clear given the wide variations in earnings over the five years.
1. The lowest possible value, assuming zero growth, is as follows.
Value cum div =
It is not likely that this will be the basis taken. [1 mark]
2. Looking at dividend growth over the past five years we have:
2004 dividend = $25,000
2000 dividend = $20,500
If the annual growth rate in dividends is g
(1 + g)4 = 25,000/20,500 = 1.2195
1 + g = 1.0508
g = 0.0508, say 5% [2 marks]
Then, MV cum div = + current dividend
=
= $400,000 [2 marks]
3. Using the Gordon’s Growth model, we have:
Average proportion retained =
(say b = 0.5)
Return on investment this year = 53,200 / average investment
=
= 0.1208 (say r = 12%)
Then g = 0.5 x 12% = 6%
So MV cum div =
(a)(v)
P/E ratio model
Comparable quoted companies to Manon have P/E ratios of about 10. Manon is much smaller an being unquoted its P/E ratio would be less than 10, but how much less?
If we take a P/E ratio of 5, we have MV = $53,200 x 5 = $266,000.
If we take a P/E ratio of 10 x 2/3, we have MV = $53,200 x 10 x 2/3 = $354,667.
If we take a P/E ratio of 10, we have MV = $532,000
[3 marks]
(b)(i)
The statement of financial position value
The statement of financial position value should not play a part in the negotiation process. Historical costs are not relevant to a decision on the future value of the company.
(b)(ii)
The replacement cost
This gives the cost of setting up a similar business. Since this gives a higher figure than any other valuation in this case, it could show the maximum price for Carmen to offer. There is clearly no goodwill to value. [1 mark]
(b)(iii)
The realizable value
This shows the cash which the shareholders in Manon could get by liquidating the business. It is therefore the minimum price which they would accept.
All the methods (i) to (iii) suffer from the limitation that they do not look at the going concern value of the business as a whole. Methods (iv) and (v) do consider this value. However, the realizable value is of use in assessing the risk attached to the business as a going concern, as it gives the base value if things go wrong and the business has to be abandoned.
[1 – 2 marks]
(b)(iv)
The dividend model
The figures have been calculated using Manon’s Ke (12%). If (2) or (3) were followed, the value would be the minimum that Manon’s shareholders would accept, as the value in use exceeds scrap value in (iii). The relevance of a dividend valuation to Carmen will depend on whether the current retention and reinvestment policies would be continued. Certainly the value to Carmen should be based on 9% rather than 12%. Both companies are ungeared and in the same risk class so the different required returns must be due to their relative sizes and the fact that Carmen’s shares are more marketable.
One of the main limitations on the dividend growth model is the problem of estimating the future value of g.
[1 – 2 marks]
(b)(v)
The P/E ratio model
The P/E ratio model is an attempt to get at the value which the market would put on a company like Manon. It does provide an external yardstick, but is a very crude measure. As already stated, P/E ratio which applies to larger quoted companies must be lowered to allow for the size of Manon and the non-marketability of its shares. Another limitation of P/E ratios is that the ratio is very dependent on the expected future growth of the firm. It is therefore not easy to find a P/E ratio of a similar firm. However, in practice the P/E model may well feature in the negotiations over price simply because it is an easily understood yardstick.
[1 – 2 marks]
(c)
The range within which the purchase price is likely to be agreed will be the minimum price which the shareholders of Manon will accept and the maximum price which the directors of Carmen will pay.
Examining the figures in part (a), the range is $291,700 (realizable value) to $561,600 (replacement cost).
[maxi. 6 marks]
Answer 2
(a)
Net assets according to the statement of financial position
Value = $295,000 [1 mark]
Reservation
NBV does not give a fair reflection of asset values. [1 mark]
(b)
Net realisable value of assets
$000Garage / 150
Other non-current assets / 2
Cars – Masoringhi / 200
– Ferrati / 130
Shares in BAC / 25
Other NCA / 27
534
Less: Bank loan / (50)
484
Value = $484,000 [2 marks]
Reservations
l Unlikely to sell the Masoringhi for $200,000 – may not even be able to recover the cost of $120,000. Therefore, the valuation is likely to be too high.
l Should the value of current assets (e.g. receivables) be written down?
[2 marks]
(c)
P/E ratio method
First, a suitable P/E ratio must be found. The main problem here is that none of the companies mentioned has the same type of trade as the target. In particular, none deals with second-hand Italian sports cars. The ratio for Volvo should definitely be excluded – Nick does not make cars. A weighted average for the rest makes sense as this will incorporate selling cars and providing garage services.
[2 marks]
P/E ratio = = 15.9 [1 mark]
It is usual to discount the P/E ratio of quoted companies when using it to value unquoted businesses. This reflects lack of marketability of shares, management skills, etc.
Therefore, a suitable P/E ratio would be 15.9 × 75% ≈ 12. [1 mark]
One could apply this ratio to last year’s earnings of $133,000, giving a value of approximately $1.6 million. However, this figure of $133,000 is unlikely to be sustainable because
l the car market is depressed
l most sales are to Nick’s personal friends.
[2 marks]
At worst a profit excluding car sales should be used.
$000Gross profit on garage / 40
Dividends / 1
Interest / (8)
33
This gives a market value of 12 × 33,000 = $396,000.
A common technique is to value the buildings separately and charge a market rent when using a P/E ratio.
Revised profit = 33,000 – 15,000 = $18,000 per annum
∴ Value = 150,000 (buildings) + (12 × 18,000) = $366,000
[1 – 2 marks]
Note: The shares in BCA are considered to be a trade investment, so have not been adjusted in the same way as the buildings.
This hybrid technique for refining the P/E based approach could be taken one step further to give the following.
$000MV = Value of cars / 330
+ Value of building / 150
+ Value of the rest of the business (12 × 18,000) / 216
696
[1 – 2 marks]
Reservations
l P/E ratios used are for companies very different from that of Nick’s garage.
l Is 25% too big/too small a discount?
l Difficult to predict future sustainable earnings based on one year’s results and without Nick’s contacts.
[1 – 2 marks]
Answer 3
(a)
Why convertibles might be an attractive source of finance for companies
l Convertibles can provide immediate finance at lower cost since the conversion option effectively reduces the interest rates payable.
l They represent attractive investments to investors since they are effectively debt risks for future equity benefits. Hence, finance is relatively easily raised.
l Should the company’s assumption regarding the likelihood of conversion prove true then there is no problem of establishing a large sinking fund for the redemption of the debentures.
l Convertibles allow for higher gearing levels than would otherwise be the case with straight debt (interest costs are potentially lower with convertibles).
[4 marks]
(b)(i)
Calculate PV of cash flows
Year / Cash flows ($) / DF @ 15% / PV ($)1 / 8 / 0.870 / 6.96
2 / 8 / 0.756 / 6.05
3 / 8 / 0.658 / 5.26
4 / 8 / 0.572 / 4.57
5 / 8 / 0.497 / 3.97
5 / 4 × 45 = 180 / 0.497 / 89.46
116.27
[4 marks]
The value of 45 shares in 5 years’ time is expected to be $4 × 45 = $180. The value of debenture redemption will be $110. Hence it is likely that conversion will take place.
[1 mark]
(b)(ii)
Arguably, the most important reservation concerns the future value of the share since it is likely to be the most uncertain aspect of the calculation. Other factors that may be relevant, but which are less uncertain, are issue price, and the cost of capital used. [2 marks]
(c)
By maximising the conversion premium the greatest amount of funds are raised for the fewest number of new shares issued.
Companies can issue convertibles with a high conversion premium because, firstly, the calculation in part (b)(i) produces a positive NPV against issue costs and, secondly, because there is high growth potential in share value.
[4 marks]
(d)
The factors that should be considered by a company when choosing between an issue of debt and issue of equity finance could include the following:
Risk and Return
Raising debt finance will increase the gearing and the financial risk of the company, while raising equity finance will lower gearing and financial risk.
Financial risk arises since raising debt brings a commitment to meet regular interest payments, whether fixed or variable. Failure to meet these interest payments gives debt holders the right to appoint a receiver to recover their investment. In contrast, there is no right to receive dividends on ordinary shares, only a right to participate in any dividend (share of profit) declared by the directors of a company. If profits are low, then dividends can be passed, but interest must be paid regardless of the level of profits. Furthermore, increasing the level of interest payments will increase the volatility of returns to shareholders, since only returns in excess of the cost of debt accrue to shareholders.
[1 – 2 marks]
Cost
Debt is cheaper than equity because debt is less risky from an investor point of view. This is because it is often secured by either a fixed or floating charge on company assets and ranks above equity on liquidation, and because of the statutory requirement to pay interest. Debt is also cheaper than equity because interest is an allowable deduction in calculating taxable profit. This is referred to as the tax efficiency of debt.
[1 – 2 marks]
Ownership and Control
Issuing equity can have ownership implications for a company, particularly if the finance is raised by a placing or offer for sale. Shareholders also have the right to appoint directors and auditors, and the right to attend general meetings of the company. While issuing debt has no such ownership implications, an issue of debt can place restrictions on the activities of a company by means of restrictive covenants included in issue documents such as debenture trust deeds. For example, a restrictive covenant may specify a maximum level of gearing or a minimum level of interest cover, or may forbid the securing of further debt on particular assets.
[1 – 2 marks]
Redemption
Equity finance is permanent capital that does not need to be redeemed, while debt finance will need to be redeemed at some future date. Redeeming a large amount of debt can place a severe strain on the cash flow of a company, although this can be addressed by refinancing or by using convertible debt.
[1 – 2 marks]
Flexibility
Debt finance is more flexible than equity, in that various amounts can be borrowed, at a fixed or floating interest rate and for a range of maturities, to suit the financing need of a company. If debt finance is no longer required, it can more easily be repaid (depending on the issue terms).
[1 – 2 marks]
Availability
A new issue of equity finance may not be readily available to a listed company or may be available on terms that are unacceptable with regards to issue price or issue quantity, if the stock market is depressed (a bear market). Current shareholders may be unwilling to subscribe to a rights issue, for example if they have made other investment plans or if they have urgent calls on their existing finances. A new issue of debt finance may not be available to a listed company, or available at a cost considered to be unacceptable, if it has a poor credit rating, or if it faces trading difficulties.
[1 – 2 marks]
Answer 4
(a)(i)
Price/earnings ratio method valuation
Earnings per share of Danoca Co = 40c
Average sector price/earnings ratio = 10
Implied value of ordinary share of Danoca Co = 40 x 10 = $4·00
Number of ordinary shares = 5 million
Value of Danoca Co = 4·00 x 5m = $20 million [2 marks]
(a)(ii)
Dividend growth model
Earnings per share of Danoca Co = 40c
Proposed payout ratio = 60%
Proposed dividend of Danoca Co is therefore = 40 x 0·6 = 24c per share [1 mark]
If the future dividend growth rate is expected to continue the historical trend in dividends per share, the historic dividend growth rate can be used as a substitute for the expected future dividend growth rate in the dividend growth model. Average geometric dividend growth rate over the last two years = (24/ 22)1/2 = 1·045 or 4·5%